For many investors, the combination of using a highly liquid ETF vehicle alongside a traditional separate account may allow for both optimal liquidity management and active alpha generation.
Institutional investors have a curious relationship with portfolio liquidity. They clearly value it, given the degree to which liquid market strategies dominate their strategic asset allocations, yet these mandates often remain static across time—while the securities that provide the underlying liquidity sit just out of reach in externally managed portfolios.
Maintaining ready access to capital does preserve valuable flexibility, but it usually comes at a cost in the form of lower potential returns. Investors commonly approach this challenge in two ways: by constraining exposure to illiquid asset categories within the broader portfolio and by identifying a strategy for managing highly liquid assets in response to fund flows and allocation changes. We have previously addressed the former topic; in this paper, we turn to the latter.
Choosing investment vehicles that are optimized to deliver liquidity on demand makes sense. They’re useful for predictable operational purposes, such as making benefit payments or delivering institutional support, and for more tactical investment purposes, such as rebalancing allocations and adjusting risk exposures in dynamic market environments. In some cases, traditional investment vehicles may be adequate to the task, but in others, clear opportunities for improvement appear. Such differences matter. If an investor can gain liquidity at no cost, a clear benefit exists, but if an investor gives up liquidity for no apparent gain, the reverse is certainly true.
The case against engineered illiquidity
Consider this: In a modern financial market where trades can be executed in microseconds, many institutional investors still consider commingled funds (which offer end-of-day pricing) and separate accounts (which offer delayed liquidity subject to communicating instructions to a manager, who must then execute a sale) to be the most liquid investments available. But we should recognize two things. First, these vehicles are less liquid than the securities held within them; second, they impose a constraint on access to capital for which there is no clear compensation.
Fortunately, a practical solution is at hand: Investors can redirect a portion of their portfolios to an ETF program that offers access to real-time liquidity. ETFs are transacted on an exchange, where, by definition, a buyer matches every seller and trades occur in real time at a single market price. This certainty is particularly useful in stressed markets when investors need to obtain a specific amount of liquidity or adjust their portfolio risk in real time.
Importantly, this flexibility does not materially constrain an investor’s ability to implement a diversified strategic asset allocation. An investor can construct an ETF program to mimic the broader allocation, ensuring that the portfolio’s exposure to market risk remains the same whenever a need for rapid rebalancing arises. If fund inflows, outflows or portfolio reallocations demand a rapid response, ETFs facilitate the most timely and effective means of execution. For this reason, they serve as an attractive complement to other types of investment vehicles. An investor using an ETF strategy as the primary source of portfolio liquidity can provide the remainder of the asset allocation with some protection from capital calls that might impair performance.
As illustrated in Exhibit 1, virtually all components of a diversified allocation can be replicated with a corresponding ETF strategy—the primary exception being illiquid private strategies. The scale of the ETF program need not be large relative to an investor’s broader portfolio but simply represent a level adequate to absorb short-term liquidity needs.
The majority of all liquid investment strategies in a diversified portfolio can be replicated with ETFs
Exhibit 1: Matching an ETF strategy to a sample portfolio by asset class
Vehicles determine liquidity as much as assets do
Actively managed funds and separate accounts are essential components of investor portfolios, but they have some drawbacks when investors seek to manage liquidity. If a particular security is illiquid, either by its nature or due to some temporary market dislocation, holding that security within a commingled fund doesn’t make it more liquid. Although it is possible for a fund manager to balance inflows and outflows without selling any underlying assets, that possibility tends to disappear in volatile markets when flows are moving in one direction. In such circumstances, those investors who sell first may benefit from the manager having access to the more liquid instruments within the portfolio, while those who remain in the fund longer may pay a higher cost for liquidity later. This effect can occur across many market sectors, but it is particularly important in fixed income markets where over-the-counter trading is the norm.
Similarly, asking a separate account manager to create liquidity from a portfolio on short notice forces some difficult choices. Should a manager monetize the most liquid assets first and thereby leave the remaining portfolio less able to meet redemptions? Or should the manager take a more patient and balanced approach to liquidating assets but extend the time frame in which capital is made available? Wouldn’t the liquid assets be better used as dry powder to fund opportunistic trades rather than meeting redemptions? For many investors, the combination of using a highly liquid ETF vehicle alongside a traditional separate account may allow for both optimal liquidity management and active alpha generation.
The top-down view of institutional liquidity needs
For most institutional investors, an inverse relationship exists between the scope of an investment decision and its urgency. Strategic allocation changes, which impact the entire portfolio, are infrequent by design and are implemented at a measured pace. Margin calls or tactical risk adjustments, by contrast, may be smaller in scope but demand more immediate action. Exhibit 2 lays out common types of portfolio adjustments and assigns a (somewhat subjective) level of timing and urgency to each.
Exhibit 2: Putting portfolio flows in context: The inverse relationship between scope and time sensitivity
Exhibit 2 suggests that for major strategic changes—and for most regular flows into and out of an allocation—the choice of investment vehicle is not vitally important; decisions are not driven by near-term conditions, and the timing of execution is known well in advance. For portfolio changes that occur in reaction to immediate market conditions, however, the opposite is true: Vehicle choices do matter. The importance of real-time liquidity increases along with the influence of immediate market conditions on the decision-making process.
But recognizing this urgency is not the same thing as identifying an effective solution, and this situation is one in which the attributes of ETFs are clearly aligned with investors’ needs. An ETF strategy, such as the one we describe below, can streamline the normally cumbersome process of moving money across market sectors and managers while maintaining transparency and ensuring that a portfolio is always 100% invested. Furthermore, an investor’s ability to move capital in advance of others with similar objectives and response functions—but less nimble allocations—can impart a meaningful performance advantage in dynamic market environments.
Optimizing active and passive exposures
For an investor already using passive beta in a commingled fund or separate account, replacing a portion of the exposure with an ETF presents few strategic challenges. Performance and fees across passive funds and ETFs are generally comparable, and—considering the flexibility that an ETF adds—investors could be justified in accepting a slightly higher price.
But in cases where the strategic asset allocation calls for investment in actively managed strategies, asset owners may find it less appealing to settle for a passive solution. Fortunately, a wide variety of active ETFs are available, allowing investors to re-create a more precise image of their current portfolio in ETF form. In many cases, investors would be able to assign the same asset management firm, and even the same portfolio management team, to provide the corresponding strategy in ETF form—keeping the benefits of active management while adding the enhanced liquidity characteristics of an ETF vehicle.
Combining the security selection and risk management expertise of an active manager with the ease of implementation and liquidity benefits of an ETF vehicle can make for a powerful combination. In addition, the majority of active ETFs currently in the market are fully transparent, just like their passive counterparts, and give investors an ability to track their underlying exposures on a daily basis.
The structure of an institutional ETF program
An effective ETF strategy should be designed with two particular dimensions in mind:
- The scope of the ETF program should allow for liquidity to be drawn optimally from across the broadest possible portion of the allocation spectrum. The widespread availability of ETFs for short-term core fixed income and broad and narrow equity sectors, as well as other subcategories, such as commodities and REITS, would allow a diversified ETF program to stand in for most of the strategic asset allocation. For the same reason, a broad-based approach would allow investors to rebalance market risk quickly within the ETF program in response to changing conditions.
- The scale of the ETF program should be large enough to absorb short-term liquidity needs and allow for tactical risk rebalancing consistent with the strategic asset allocation and investment policy. Although this view is subjective for each investor, a target of 5%–10% of an allocation could be implemented via ETFs to achieve this objective.
The degree of customization within an ETF program can be tailored to an investor’s specific needs. We outline three potential solutions, with increasing degrees of complexity, in Exhibit 3.
Investors can choose to implement a range of ETF strategies to replicate their strategic asset allocations as finely as necessary to ensure consistency of exposures
Exhibit 3: An illustration of sample ETF programs across major market segments
The progression in Exhibit 3 illustrates the potential to strike a balance between ease of implementation and comprehensive replication of a broader strategic asset allocation in an ETF program. In the first iteration (1.0), the program requires only three ETFs to gain exposure to the most significant portfolio holdings: stocks, bonds and cash. In the second iteration (2.0), the program expands to include a broader mix of U.S. equity factors, as well as core bonds and REITS—more effectively replicating the broader strategic allocation. Finally, the third iteration (3.0) relies on active management and factor-based strategies wherever possible to improve risk and return across the ETF program.
Free insurance is usually a pretty good deal
Liquidity can be thought of as a form of insurance: We pay a price for having it, but on infrequent occasions it has enormous value. Higher returns are available for those investors willing to forgo ready access to capital, but care must be taken not to restrict flexibility as well. At the strategic asset allocation level, investors consistently demonstrate a preference for maintaining prudently high levels of liquidity across their portfolios—even though they must sacrifice a margin of potential return for the privilege.
But when it comes to the more practical elements of liquidity management, investors seem willing to forgo opportunities to maximize the flexibility of those components at little or no cost. The ability to substitute a more liquid vehicle for a less liquid one, while maintaining effectively identical market exposure, has been largely overlooked. That is the deal offered by ETFs, and it is a pretty good one. The value won’t be visible day in and day out, but at those moments when liquidity is most valuable it will shine through.
APPENDIX: ETF Liquidity in Stressed Markets
Investors’ ability to use ETFs to manage portfolio flows and rebalance transactions depends on the power of these funds to track the underlying market accurately while still offering enhanced liquidity relative to other investment vehicles. The emergence of an imbalance of buyers or sellers in the secondary (exchange-traded) market, for example, could be a cause for concern among investors if it forced transactions in the primary market, where ETFs are created or redeemed using the underlying securities themselves.
Few ETF sectors have faced as much scrutiny in this regard as those based on high yield bonds. The underlying securities’ relatively high volatility and low liquidity could pose serious challenges for investors if the secondary ETF market were to become imbalanced and drive large flows in the cash bond market. Fortunately, our examination of market behavior in recent years suggests that these concerns are largely unfounded; high yield ETFs have proven to be superior vehicles for managing risk, even in times of market stress.
Exhibit 4 highlights how high yield ETFs have responded to moments of market volatility, when liquidity in the underlying bonds became scarce. We have observed that secondary market volume in high yield ETFs actually increases as a percentage of total high yield bond trading volume in times of stress (purple line). Furthermore, this increase in secondary market volume does not result in a higher percentage of primary market creation/redemption activity in the bonds by the ETFs. This heightened trading during periods of market stress shows how investors—whether institutional or retail—gravitate toward ETFs, which provide a necessary outlet of liquidity between buyers and sellers on the exchange (and act as a risk-transfer vehicle) above the underlying high yield bond market. A tremendous amount of high yield ETF exposure is traded per week, but only a limited amount of that activity actually touches the underlying market at any given time.
Secondary market volume in high yield ETFs tends to increase at times of market stress, when liquidity in the underlying securities appears limited
Exhibit 4: High yield ETFs in stressed markets (20-day rolling average)
The evolution of pension hedging
As part of the Allocation Spotlight Series, Jared Gross, Head of Institutional Portfolio Strategy, Kay Herr, Head of Fixed Income Research, and Lisa Coleman, Head of the Global Investment Grade Corporate Credit Team, discuss the current market environment--from ratings migration to fallen angels and rising stars--and the evolution of pension hedging strategy in LDI portfolios.